[Federal Register Volume 75, Number 86 (Wednesday, May 5, 2010)]
[Notices]
[Pages 24648-24655]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-10335]


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COMMODITY FUTURES TRADING COMMISSION


Order Finding That the Socal Border Financial Basis Contract 
Traded on the IntercontinentalExchange, Inc., Performs a Significant 
Price Discovery Function

AGENCY: Commodity Futures Trading Commission.

ACTION: Final order.

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SUMMARY: On October 20, 2009, the Commodity Futures Trading Commission 
(``CFTC'' or ``Commission'') published for comment in the Federal 
Register \1\ a notice of its intent to undertake a determination 
whether the Socal Border Financial Basis (``SCL'') contract traded on 
the IntercontinentalExchange, Inc. (``ICE''), an exempt commercial 
market (``ECM'') under sections 2(h)(3)-(5) of the Commodity Exchange 
Act (``CEA'' or the ``Act''), performs a significant price discovery 
function pursuant to section 2(h)(7) of the CEA.\2\ The Commission 
undertook this review based upon an initial evaluation of information 
and data provided by ICE as well as other available information. The 
Commission has reviewed the entire record in this matter, including all 
comments received, and has determined to issue an order finding that 
the SCL contract performs a significant price discovery function. 
Authority for this action is found in section 2(h)(7) of the CEA and 
Commission rule 36.3(c) promulgated thereunder.
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    \1\ 74 FR 53723 (October 20, 2009).
    \2\ 7 U.S.C. 1a(29).

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DATES: Effective date: April 28, 2010.

FOR FURTHER INFORMATION CONTACT: Gregory K. Price, Industry Economist, 
Division of Market Oversight, Commodity Futures Trading Commission, 
Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. 
Telephone: (202) 418-5515. E-mail: <a href="/cdn-cgi/l/email-protection#5d3a2d2f343e381d3e3b293e733a322b"><span class="__cf_email__" data-cfemail="026572706b616742616476612c656d74">[email protected]</span></a>; or Susan Nathan, 
Senior Special Counsel, Division of Market Oversight, same address. 
Telephone: (202) 418-5133. E-mail: <a href="/cdn-cgi/l/email-protection#ed9e838c99858c83ad8e8b998ec38a829b"><span class="__cf_email__" data-cfemail="84f7eae5f0ece5eac4e7e2f0e7aae3ebf2">[email protected]</span></a>.

SUPPLEMENTARY INFORMATION: 

I. Introduction

    The CFTC Reauthorization Act of 2008 (``Reauthorization Act'') \3\ 
significantly broadened the CFTC's regulatory authority with respect to 
ECMs by creating, in section 2(h)(7) of the CEA, a new regulatory 
category--

[[Page 24649]]

ECMs on which significant price discovery contracts (``SPDCs'') are 
traded--and treating ECMs in that category as registered entities under 
the CEA. The legislation authorizes the CFTC to designate an agreement, 
contract or transaction as a SPDC if the Commission determines, under 
criteria established in section 2(h)(7), that it performs a significant 
price discovery function. When the Commission makes such a 
determination, the ECM on which the SPDC is traded must assume, with 
respect to that contract, all the responsibilities and obligations of a 
registered entity under the Act and Commission regulations, and must 
comply with nine core principles established by new section 2(h)(7)(C).
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    \3\ Incorporated as Title XIII of the Food, Conservation and 
Energy Act of 2008, Public Law 110-246, 122 Stat. 1624 (June 18, 
2008).
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    On March 16, 2009, the CFTC promulgated final rules implementing 
the provisions of the Reauthorization Act.\4\ As relevant here, rule 
36.3 imposes increased information reporting requirements on ECMs to 
assist the Commission in making prompt assessments whether particular 
ECM contracts may be SPDCs. In addition to filing quarterly reports of 
its contracts, an ECM must notify the Commission promptly concerning 
any contract traded in reliance on the exemption in section 2(h)(3) of 
the CEA that averaged five trades per day or more over the most recent 
calendar quarter, and for which the exchange sells its price 
information regarding the contract to market participants or industry 
publications, or whose daily closing or settlement prices on 95 percent 
or more of the days in the most recent quarter were within 2.5 percent 
of the contemporaneously determined closing, settlement or other daily 
prices of another contract.
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    \4\ 74 FR 12178 (Mar. 23, 2009); these rules became effective on 
April 22, 2009.
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    Commission rule 36.3(c)(3) established the procedures by which the 
Commission makes and announces its determination whether a particular 
ECM contract serves a significant price discovery function. Under those 
procedures, the Commission will publish notice in the Federal Register 
that it intends to undertake an evaluation whether the specified 
agreement, contract or transaction performs a significant price 
discovery function and to receive written views, data and arguments 
relevant to its determination from the ECM and other interested 
persons. Upon the close of the comment period, the Commission will 
consider, among other things, all relevant information regarding the 
subject contract and issue an order announcing and explaining its 
determination whether or not the contract is a SPDC. The issuance of an 
affirmative order signals the effectiveness of the Commission's 
regulatory authorities over an ECM with respect to a SPDC; at that time 
such an ECM becomes subject to all provisions of the CEA applicable to 
registered entities.\5\ The issuance of such an order also triggers the 
obligations, requirements and timetables prescribed in Commission rule 
36.3(c)(4).\6\
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    \5\ Public Law 110-246 at 13203; Joint Explanatory Statement of 
the Committee of Conference, H.R. Rep. No. 110-627, 110 Cong., 2d 
Sess. 978, 986 (Conference Committee Report). See also 73 FR 75888, 
75894 (Dec. 12, 2008).
    \6\ For an initial SPDC, ECMs have a grace period of 90 calendar 
days from the issuance of a SPDC determination order to submit a 
written demonstration of compliance with the applicable core 
principles. For subsequent SPDCs, ECMs have a grace period of 30 
calendar days to demonstrate core principle compliance.
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II. Notice of Intent To Undertake SPDC Determination

    On October 20, 2009, the Commission published in the Federal 
Register notice of its intent to undertake a determination whether the 
SCL contract performs a significant price discovery function and 
requested comment from interested parties.\7\ Comments were received 
from the Federal Energy Regulatory Commission (``FERC''), Platts and 
ICE.\8\ The comment letters from FERC \9\ and Platts did not directly 
address the issue of whether or not the SCL contract is a SPDC; ICE's 
comments raised substantive issues with respect to the applicability of 
section 2(h)(7) to the SCL contract. Generally, ICE asserted that its 
SCL contract is not a SPDC as it does not meet the material liquidity, 
material price reference and price linkage criteria for SPDC 
determination (CL 03). ICE's comments are more extensively discussed 
below, as applicable.
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    \7\ The Commission's Part 36 rules establish, among other 
things, procedures by which the Commission makes and announces its 
determination whether a specific ECM contract serves a significant 
price discovery function. Under those procedures, the Commission 
publishes a notice in the Federal Register that it intends to 
undertake a determination whether a specified agreement, contract or 
transaction performs a significant price discovery function and to 
receive written data, views and arguments relevant to its 
determination from the ECM and other interested persons.
    \8\ FERC is an independent federal regulatory agency that, among 
other things, regulates the interstate transmission of natural gas, 
oil and electricity. McGraw-Hill, through its division Platts, 
compiles and calculates monthly natural gas price indices from 
natural gas trade data submitted to Platts by energy marketers. 
Platts includes those price indices in its monthly Inside FERC's Gas 
Market Report (``Inside FERC''). ICE is an exempt commercial market, 
as noted above. The comment letters are available on the 
Commission's Web site: http://www.cftc.gov/lawandregulation/federalregister/federalregistercomments/2009/09-028.html.
    \9\ FERC stated that the SCL contract is cash settled and does 
not contemplate the actual physical delivery of natural gas. 
Accordingly, FERC expressed the opinion that a determination by the 
Commission that a contract performs a significant price discovery 
function ``would not appear to conflict with FERC's exclusive 
jurisdiction under the Natural Gas Act (NGA) over certain sales of 
natural gas in interstate commerce for resale or with its other 
regulatory responsibilities under the NGA'' and further that ``FERC 
staff will continue to monitor for any such conflict * * * [and] 
advise the CFTC'' should any such potential conflict arise. CL 01.
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III. Section 2(h)(7) of the CEA

    The Commission is directed by section 2(h)(7) of the CEA to 
consider the following criteria in determining a contract's significant 
price discovery function:
    <bullet> Price Linkage--the extent to which the agreement, contract 
or transaction uses or otherwise relies on a daily or final settlement 
price, or other major price parameter, of a contract or contracts 
listed for trading on or subject to the rules of a designated contract 
market (``DCM'') or derivatives transaction execution facility 
(``DTEF''), or a SPDC traded on an electronic trading facility, to 
value a position, transfer or convert a position, cash or financially 
settle a position, or close out a position.
    <bullet> Arbitrage--the extent to which the price for the 
agreement, contract or transaction is sufficiently related to the price 
of a contract or contracts listed for trading on or subject to the 
rules of a DCM or DTEF, or a SPDC traded on or subject to the rules of 
an electronic trading facility, so as to permit market participants to 
effectively arbitrage between the markets by simultaneously maintaining 
positions or executing trades in the contracts on a frequent and 
recurring basis.
    <bullet> Material price reference--the extent to which, on a 
frequent and recurring basis, bids, offers or transactions in a 
commodity are directly based on, or are determined by referencing or 
consulting, the prices generated by agreements, contracts or 
transactions being traded or executed on the electronic trading 
facility.
    <bullet> Material liquidity--the extent to which the volume of 
agreements, contracts or transactions in a commodity being traded on 
the electronic trading facility is sufficient to have a material effect 
on other agreements, contracts or transactions listed for trading on or 
subject to the rules of a DCM, DTEF or electronic trading facility 
operating in reliance on the exemption in section 2(h)(3).

[[Page 24650]]

    Not all criteria must be present to support a determination that a 
particular contract performs a significant price discovery function, 
and one or more criteria may be inapplicable to a particular 
contract.\10\ Moreover, the statutory language neither prioritizes the 
criteria nor specifies the degree to which a SPDC must conform to the 
various criteria. In Guidance issued in connection with the Part 36 
rules governing ECMs with SPDCs, the Commission observed that these 
criteria do not lend themselves to a mechanical checklist or formulaic 
analysis. Accordingly, the Commission has indicated that in making its 
determinations it will consider the circumstances under which the 
presence of a particular criterion, or combination of criteria, would 
be sufficient to support a SPDC determination.\11\ For example, for 
contracts that are linked to other contracts or that may be arbitraged 
with other contracts, the Commission will consider whether the price of 
the potential SPDC moves in such harmony with the other contract that 
the two markets essentially become interchangeable. This co-movement of 
prices would be an indication that activity in the contract had reached 
a level sufficient for the contract to perform a significant price 
discovery function. In evaluating a contract's price discovery role as 
a price reference, the Commission will consider whether cash market 
participants are quoting bid or offer prices or entering into 
transactions at prices that are set either explicitly or implicitly at 
a differential to prices established for the contract.
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    \10\ In its October 20, 2009, Federal Register release, the 
Commission identified material liquidity, material price reference 
and price linkage as the possible criteria for SPDC determination of 
the SCL contract. Arbitrage was not identified as a possible 
criterion and will not be discussed further in this document or the 
associated Order.
    \11\ 17 CFR part 36, Appendix A.
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IV. Findings and Conclusions

a. The Socal Border Financial Basis (SCL) Contract and the SPDC Indicia

    The SCL contract is cash settled based on the difference between 
the price of natural gas at the Southern California Border hub for the 
month of delivery, as published in Intelligence Press Inc.'s 
(``IPI's'') Natural Gas Bidweek Survey, and the final settlement price 
for New York Mercantile Exchange's (``NYMEX's'') Henry Hub physically-
delivered natural gas futures contract for the same specified calendar 
month. The IPI bidweek price, which is published monthly, is based on a 
survey of cash market traders who voluntarily report to IPI data on 
fixed-price transactions for physical delivery of natural gas at the 
Socal Border hub conducted during the last five business days of the 
month; such bidweek transactions specify the delivery of natural gas on 
a uniform basis throughout the following calendar month at the agreed 
upon rate. The IPI bidweek index is published on the first business day 
of the calendar month in which the natural gas is to be delivered. The 
size of the SCL contract is 2,500 million British thermal units 
(``mmBtu''), and the unit of trading is any multiple of 2,500 mmBtu. 
The SCL contract is listed for up to 120 calendar months commencing 
with the next calendar month.
    The Henry Hub,\12\ which is located in Erath, Louisiana, is the 
primary cash market trading and distribution center for natural gas in 
the United States. It also is the delivery point and pricing basis for 
the NYMEX's actively traded, physically-delivered natural gas futures 
contract, which is the most important pricing reference for natural gas 
in the United States. The Henry Hub, which is operated by Sabine Pipe 
Line, LLC, serves as a juncture for 13 different pipelines. These 
pipelines bring in natural gas from fields in the Gulf Coast region and 
ship it to major consumption centers along the East Coast and Midwest. 
The throughput shipping capacity of the Henry Hub is 1.8 trillion mmBtu 
per day.
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    \12\ The term ``hub'' refers to a juncture where two or more 
natural gas pipelines are connected. Hubs also serve as pricing 
points for natural gas at the particular locations.
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    In addition to the Henry Hub, there are a number of other locations 
where natural gas is traded. In 2008, there were 33 natural gas market 
centers in North America.\13\ Some of the major trading centers include 
Alberta, Northwest Rockies, Socal and the Houston Ship Channel. For 
locations that are directly connected to the Henry Hub by one or more 
pipelines and where there typically is adequate shipping capacity, the 
price at the other locations usually directly tracks the price at the 
Henry Hub, adjusted for transportation costs. However, at other 
locations that are not directly connected to the Henry Hub or where 
shipping capacity is limited, the prices at those locations often 
diverge from the Henry Hub price. Furthermore, one local price may be 
significantly different than the price at another location even though 
the two markets' respective distances from the Henry Hub are the same. 
The reason for such pricing disparities is that a given location may 
experience supply and demand factors that are specific to that region, 
such as differences in pipeline shipping capacity, unusually high or 
low demand for heating or cooling or supply disruptions caused by 
severe weather. As a consequence, local natural gas prices can differ 
from the Henry Hub price by more than the cost of shipping and such 
price differences can vary in an unpredictable manner.
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    \13\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.
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    The Socal Border hub is located in Southern California on the 
border with Arizona.\14\ The California Energy Hub, a market center 
that includes the Socal Border Hub, had an estimated throughput 
capacity of 900 million cubic feet per day. Moreover, the number of 
pipeline interconnections at the California Energy Hub was 12 in 2008, 
up from five in 2003. Lastly, the pipeline interconnection capacity of 
the California Energy Hub in 2008 was 6,784 million cubic feet per day, 
which constituted a 47 percent increase over the pipeline 
interconnection capacity in 2003.\15\ The Socal Border hub is far 
removed from the Henry Hub and is not directly connected to the Henry 
Hub by an existing pipeline.
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    \14\ The Socal Border hub typically includes fixed-price gas 
delivered into Southern California Gas Co.'s pipeline system from El 
Paso Corp.'s pipeline at Topock and Blythe, CA/Ehrenberg, AZ; from 
Kern River Gas Transmission Co.'s pipeline at Wheeler Ridge and 
Kramer Junction, CA; and from Questar Pipeline Co.'s Southern Trail 
Pipeline at Needles, CA. The Socal price index includes deliveries 
from Pacific Gas and Electric at several points, including the Kern 
River station and Pisgah/Daggett, as well as in-state production.
    \15\ See http://www.eia.doe.gov/pub/oil_gas/natural_gas/feature_articles/2009/ngmarketcenter/ngmarketcenter.pdf.
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    For all these reasons, the local price at the Socal hub typically 
differs from the price at the Henry Hub. Thus, the price of the Henry 
Hub physically-delivered futures contract is an imperfect proxy for the 
Socal Border price. Moreover, exogenous factors, such as adverse 
weather, can cause the Socal gas price to differ from the Henry Hub 
price by an amount that is more or less than the cost of shipping, 
making the NYMEX Henry Hub futures contract even less precise as a 
hedging tool than desired by market participants. Basis contracts \16\ 
allow traders to more accurately discover prices at alternative 
locations and hedge price risk that is associated with natural gas at 
such locations.\17\ In this regard, a position at

[[Page 24651]]

a local price for an alternative location can be established by adding 
the appropriate basis swap position to a position taken in the NYMEX 
physically-delivered Henry Hub contract (or in the NYMEX or ICE Henry 
Hub look-alike contract, which cash settle based on the NYMEX 
physically-delivered natural gas contract's final settlement price).
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    \16\ Basis contracts denote the difference in the price of 
natural gas at a specified location minus the price of natural gas 
at the Henry Hub. The differential can be either a positive or 
negative value.
    \17\ Commercial activity in natural gas basis swap contracts is 
evidenced by large positions held by energy trading firms in the 
comparable NYMEX ClearPort basis swap contract for the Socal hub.
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    In its October 20, 2009, Federal Register notice, the Commission 
identified material liquidity, price linkage and material price 
reference as the potential SPDC criteria applicable to the SCL 
contract. Each of these criteria is discussed below.\18\
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    \18\ As noted above, the Commission did not find an indication 
of arbitrage in connection with this contract; accordingly, that 
criterion was not discussed in reference to the SCL contract.
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1. Material Price Reference Criterion
    The Commission's October 20, 2009, Federal Register notice 
identified material price reference as a potential basis for a SPDC 
determination with respect to this contract. The Commission considered 
the fact that ICE maintains exclusive rights over IPI's bidweek price 
indices. As a result, no other exchange can offer such a basis contract 
based on IPI's Socal bidweek index. While other third-party price 
providers produce natural gas price indices for this and other trading 
centers, market participants indicate that the IPI Socal bidweek index 
is highly regarded for this particular location and should market 
participants wish to establish a hedged position based on this index, 
they would need to do so by taking a position in the ICE SCL swap since 
ICE has the right to the IPI index for cash settlement purposes. In 
addition, ICE sells its price data to market participants in a number 
of different packages which vary in terms of the hubs covered, time 
periods, and whether the data are daily only or historical. For 
example, ICE offers the ``West Gas End of Day'' and ``OTC Gas End of 
Day'' \19\ packages with access to all price data or just current 
prices plus a selected number of months (i.e., 12, 24, 36 or 48 months) 
of historical data. These two packages include price data for the SCL 
contract.
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    \19\ The OTC Gas End of Day dataset includes daily settlement 
prices for natural gas contracts listed for all points in North 
America.
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    The Socal Border hub is a major trading center for natural gas in 
the United States. Traders, including producers, keep abreast of the 
prices of the SCL contract when conducting cash deals. These traders 
look to a competitively determined price as an indication of expected 
values of natural gas at the Socal Border when entering into cash 
market transactions for natural gas, especially those trades providing 
for physical delivery in the future. Traders use the ICE SCL contract, 
as well as other ICE basis swap contracts, to hedge cash market 
positions and transactions--activities which enhance the SCL contract's 
price discovery utility. The substantial volume of trading and open 
interest in the SCL contract appears to attest to its use for this 
purpose. While the SCL contract's settlement prices may not be the only 
factor influencing spot and forward transactions, natural gas traders 
consider the ICE price to be a critical factor in conducting OTC 
transactions.\20\
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    \20\ In addition to referencing ICE prices, natural gas market 
firms participating in the Socal market may rely on other cash 
market quotes as well as industry publications and price indices 
that are published by third-party price reporting firms in entering 
into natural gas transactions.
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    NYMEX lists a futures contract that is comparable to the ICE SCL 
contract on its ClearPort platform. However, unlike the ICE contract, 
none of the trades in the NYMEX SoCal Basis Swap are executed in 
NYMEX's centralized marketplace; instead, all of the transactions 
originate as bilateral swaps that are submitted to NYMEX for clearing. 
The daily settlement prices of the NYMEX SoCal Basis Swap contract are 
influenced, in part, by the daily settlement prices of the ICE SCL 
contract. This is because NYMEX determines the daily settlement prices 
for its natural gas basis swap contracts through a survey of cash 
market voice brokers. Voice brokers, in turn, refer to the ICE SCL 
price, among other information, as an important indicator as to where 
the market is trading. Therefore, the ICE SCL price influences the 
settlement price for the NYMEX SoCal Basis Swap contract. This is 
supported by an analysis of the daily settlement prices for the NYMEX 
and ICE Socal basis swap contracts. In this regard, 99 percent of the 
daily settlement prices for the NYMEX SoCal Basis Swap contract are 
within one standard deviation of the SCL contract's settlement prices.
    Lastly, the fact that the SCL contract does not meet the price 
linkage criterion (discussed below) bolsters the argument for material 
price reference. As noted above, the Henry Hub is the pricing reference 
for natural gas in the United States. However, regional market 
conditions may cause the price of natural gas in another area of the 
country to diverge by more than the cost of transportation, thus making 
the Henry Hub price an imperfect proxy for the local gas price. The 
more variable the local natural gas price is, the more traders need to 
accurately hedge their price risk. Basis swap contracts provide a means 
of more accurately pricing natural gas at a location other than the 
Henry Hub. An analysis of Socal natural gas prices showed that 93 
percent of the observations were more than 2.5 percent different that 
the contemporaneous Henry Hub prices. Specifically, the average Socal 
basis value between January 2008 and September 2009 was -$0.78 per 
mmBtu with a variance of $0.29 per mmBtu.
i. Federal Register Comments
    As noted above, ICE was the sole respondent which addressed the 
question of whether the SCL contract is a SPDC. ICE stated in its 
comment letter that the SCL contract does not meet the material price 
reference criterion for SPDC determination. ICE argued that the 
Commission appeared to base the case that the SCL contract is 
potentially a SPDC on two disputable assertions. First, in issuing its 
notice of intent to determine whether the SCL contract is a SPDC, the 
CFTC cited a general conclusion in its ECM study ``that certain market 
participants referred to ICE as a price discovery market for certain 
natural gas contracts.'' ICE states that, ``Basing a material price 
reference determination on general statements made in a two year old 
study does not seem to meet Congress' intent that the CFTC use its 
considerable expertise to study the OTC markets.'' In response to the 
above comment, the Commission notes that it cited the ECM study's 
general finding that some ICE natural gas contracts appear to be 
regarded as price discovery markets merely as an indicia that an 
investigation of certain ICE contracts may be warranted, and was not 
intended to serve as the sole basis for determining whether or not a 
particular contract meets the material price reference criterion.
    Second, ICE argued that the Commission should not base a 
determination that the SCL contract is a SPDC merely because this 
contract has the exclusive right to base its settlement on the IPI 
Socal Border Index price. While the Commission acknowledges that there 
are other firms that produce price indices for the Socal hub, as it 
notes above, market participants indicate that the IPI Index is very 
highly regarded and should they wish to establish a hedged position 
based on this index, they would need to do so by taking a position in 
the ICE SCL swap

[[Page 24652]]

since ICE has the exclusive right to use the IPI index.\21\
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    \21\ Futures and swaps based on other Socal indices have not met 
with the same market acceptance as the SCL contract. For example, 
NYMEX lists a basis swap contract that is comparable to the SCL 
contract with the exception that it uses a different price index for 
cash settlement. Open interest as of September 30, 2009, was 
approximately 75,000 contracts in the NYMEX SoCal Basis Swap 
contract versus nearly 400,000 contracts in ICE's SCL contract. 
Moreover, there has been no centralized-market trading in the NYMEX 
Socal Basis Swap contract, so that contract does not serve as a 
source of price discovery for cash market traders with natural gas 
at that location.
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ii. Conclusion Regarding Material Price Reference
    Based on the above, the Commission finds that the SCL contract 
meets the material price reference criterion because it is referenced 
and consulted on a frequent and recurring basis by cash market 
participants when pricing transactions (direct evidence). Moreover, the 
ECM sells the SCL contract's price data to market participants 
(indirect evidence).
2. Price Linkage Criterion
    In its October 20, 2009, Federal Register notice, the Commission 
identified price linkage as a potential basis for a SPDC determination 
with respect to the SCL contract. In this regard, the final settlement 
of the SCL contract is based, in part, on the final settlement price of 
the NYMEX's physically-delivered natural gas futures contract, where 
the NYMEX is registered with the Commission as a DCM.
    The Commission's Guidance on Significant Price Discovery Contracts 
\22\ notes that a ``price-linked contract is a contract that relies on 
a contract traded on another trading facility to settle, value or 
otherwise offset the price-linked contract.'' Furthermore, the Guidance 
notes that, ``[f]or a linked contract, the mere fact that a contract is 
linked to another contract will not be sufficient to support a 
determination that a contract performs a significant price discovery 
function. To assess whether such a determination is warranted, the 
Commission will examine the relationship between transaction prices of 
the linked contract and the prices of the referenced contract. The 
Commission believes that where material liquidity exists, prices for 
the linked contract would be observed to be substantially the same as 
or move substantially in conjunction with the prices of the referenced 
contract.'' Furthermore, the Guidance proposes a threshold price 
relationship such that prices of the ECM linked contract will fall 
within a 2.5 percent price range for 95 percent of contemporaneously 
determined closing, settlement or other daily prices over the most 
recent quarter. Finally, the Commission also stated in the Guidance 
that it would consider a linked contract that has a trading volume 
equivalent to 5 percent of the volume of trading in the contract to 
which it is linked to have sufficient volume potentially to be deemed a 
SPDC (``minimum threshold'').
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    \22\ Appendix A to the Part 36 rules.
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    To assess whether the SCL contract meets the price linkage 
criterion, Commission staff obtained price data from ICE and performed 
the statistical tests cited above. Staff found that, while the Socal 
Border price is determined, in part, by the final settlement price of 
the NYMEX physically-delivered natural gas futures contract (a DCM 
contract), the Socal hub price is not within 2.5 percent of the 
settlement price of the corresponding NYMEX Henry Hub natural gas 
futures contract on 95 percent or more of the days. Specifically, 
during the third quarter of 2009, only 7 percent of the Socal Border 
natural gas prices derived from the ICE basis values were within 2.5 
percent of the daily settlement price of the NYMEX Henry Hub futures 
contract. In addition, staff found that the SCL contract fails to meet 
the volume threshold requirement. In particular, the total trading 
volume in the NYMEX physically-delivered natural gas contract during 
the third quarter of 2009 was 14,022,963 contracts, with 5 percent of 
that number being 701,148 contracts. The number of trades on the ICE 
centralized market in the SCL contract during the same period was 
507,870 contracts (equivalent to 126,967 NYMEX contracts, given the 
size difference).\23\ Thus, centralized-market trades in the SCL 
contract amounted to less than the minimum threshold.
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    \23\ The SCL contract is one-quarter the size of the NYMEX Henry 
Hub physically-delivered futures contract.
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    Due to the specific criteria that a given ECM contract must meet to 
fulfill the price linkage criterion, the requirements, for all intents 
and purposes, exclude ECM contracts that are not near facsimiles of DCM 
contracts even though the ECM contract may specifically use the 
settlement price to value a position, which is the case of the SCL 
contract. In this regard, an ECM contract that is priced and traded as 
if it is a functional equivalent of a DCM contract likely will have a 
price series that mirrors that of the corresponding DCM contract. In 
contrast, for contracts that are not look-alikes of DCM contracts, it 
is reasonable to expect that the two price series would be divergent. 
The Socal Border hub and the Henry Hub are located in two different 
areas of the United States. Moreover, the Henry Hub is primarily a 
supply center while Southern California is a demand center. These 
differences contribute to the divergence between the two price series 
and, as discussed below, increase the likelihood that the ``basis'' 
contract is used for material price reference.
i. Federal Register Comments
    As noted above, ICE was the sole respondent which addressed the 
question of whether the SCL contract is a SPDC. ICE stated in its 
comment letter that the SCL contract does not meet the price linkage 
criterion for SPDC determination because it fails the volume test 
provided in the Commission's Guidance.
ii. Conclusion Regarding the Price Linkage Criterion
    Based on the above, the Commission finds that the SCL contract does 
not meet the price linkage criterion because it fails the price 
relationship and volume tests provided for in the Commission's 
Guidance.
3. Material Liquidity Criterion
    To assess whether the SCL contract meets the material liquidity 
criterion, the Commission first examined volume and open interest data 
provided to it by ICE as a general measurement of the SCL market's size 
and potential importance, and second performed a statistical analysis 
to measure the effect that changes to SCL prices potentially may have 
on prices for the NYMEX Henry Hub Natural Gas (a DCM contract), the ICE 
AECO Financial Basis contract (an ECM contract) and the HSC \24\ 
Financial Basis contract (an ECM contract).\25\
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    \24\ The acronym stands for Houston Ship Channel.
    \25\ As noted above, the material liquidity criterion speaks to 
the effect that transactions in the potential SPDC may have on 
trading in ``agreements, contracts and transactions listed for 
trading on or subject to the rules of a designated contract market, 
a derivatives transaction execution facility, or an electronic 
trading facility operating in reliance on the exemption in section 
2(h)(3) of the Act.''
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    The Commission's Guidance (Appendix A to Part 36) notes that 
``[t]raditionally, objective measures of trading such as volume or open 
interest have been used as measures of liquidity.'' In this regard, the 
Commission in its October 20, 2009, Federal Register notice referred to 
second quarter 2009 trading statistics that ICE had submitted for its 
SCL contract. Based upon on a required quarterly filing made by ICE on 
July 27, 2009, the total number of SCL trades

[[Page 24653]]

executed on ICE's electronic trading platform was 8,102 in the second 
quarter of 2009, resulting in a daily average of 126.6 trades. During 
the same period, the SCL contract had a total trading volume on ICE's 
electronic trading platform of 612,452 contracts and an average daily 
trading volume of 9,569 contracts. Moreover, the open interest as of 
June 30, 2009, was 417,121 contracts, which included trades executed on 
ICE's electronic trading platform, as well as trades executed off of 
ICE's electronic trading platform and then brought to ICE for 
clearing.\26\
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    \26\ ICE does not differentiate between open interest created by 
a transaction executed on its trading platform versus that created 
by a transaction executed off its trading platform. 74 FR 53723 
(October 20, 2009).
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    Subsequent to the October 20, 2009, Federal Register notice, ICE 
submitted another quarterly notification filed on November 13, 
2009,\27\ with updated trading statistics. Specifically, with respect 
to its SCL contract, 7,080 separate trades occurred on its electronic 
platform in the third quarter of 2009, resulting in a daily average of 
107.3 trades. During the same period, the SCL contract had a total 
trading volume on its electronic platform of 507,870 contracts (which 
was an average of 7,695 contracts per day).\28\ As of September 30, 
2009, open interest in the SCL contract was 398,875 contracts.\29\ 
Reported open interest included positions resulting from trades that 
were executed on ICE's electronic platform, as well as trades that were 
executed off of ICE's electronic platform and brought to ICE for 
clearing.
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    \27\ See Commission Rule 36.3(c)(2), 17 CFR 36.3(c)(2).
    \28\ By way of comparison, the number of contracts traded in the 
SCL contract is similar to that exhibited on a liquid futures market 
and is roughly equivalent to the volume of trading for the ICE 
Futures U.S. Cotton No. 2 futures contract during this period.
    \29\ By way of comparison, open interest in the SCL contract is 
roughly equivalent to that in the Chicago Board of Trade's soybean 
contract and the Commodity Exchange's Gold futures contract.
---------------------------------------------------------------------------

    In Appendix A to Part 36, the material liquidity criterion for SPDC 
determination specifies that an ECM contract should have a material 
effect on another contract. To measure the effect that the SCL contract 
potentially could have on a DCM contract, or on another ECM contract, 
Commission staff performed a statistical analysis \30\ using daily 
settlement prices (between January 2, 2008, and September 30, 2009) for 
the NYMEX Henry Hub natural gas contract (a DCM contract) and price 
levels for the Alberta, Houston Ship Channel (``HSC''), and Socal 
market centers.\31\ The simulation results suggest that, on average 
over the sample period, a one percent rise in the Socal natural gas 
price elicited a 0.8 percent increase in each of the Alberta, HSC, and 
NYMEX Henry Hub prices.
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    \30\ Specifically, the Commission econometrically estimated a 
vector autoregression model using daily natural gas price levels. A 
vector autoregression model is an econometric model used to capture 
the dependencies and interrelationships among multiple time series, 
generalizing the univariate autoregression model. The estimated 
model displays strong diagnostic evidence of statistical adequacy. 
In particular, the model's impulse response function was shocked 
with a one-time rise in Socal price. The simulation results suggest 
that, on average over the sample period, a one percent rise in the 
Socal natural gas price elicited a 0.8 percent increase in the NYMEX 
Henry Hub price, as well as a 0.8 percent increase in each of the 
other two modeled natural gas prices. These multipliers of response 
emerge with noticeable statistical strength or significance. Based 
on such long run sample patterns, if the Socal price rises by 10 
percent, then the price of NYMEX Henry Hub natural gas futures 
contract, as well as those for the Alberta and HSC hubs, each would 
rise by about 8 percent.
    \31\ Natural gas prices at the Alberta, HSC, and Socal trading 
centers were obtained by adding the daily settlement prices of ICE's 
AECO Financial Basis, HSC Financial Basis and Socal Border Financial 
Basis contracts, respectively, to the contemporaneous daily 
settlement prices of the NYMEX Henry Hub physically-delivered 
natural gas futures contract.
---------------------------------------------------------------------------

i. Federal Register Comments
    As noted above, ICE was the sole respondent which addressed the 
question of whether the SCL contract is a SPDC. ICE stated in its 
comment letter that the SCL contract does not meet the material 
liquidity criterion for SPDC determination for a number of reasons.
    First, ICE opined that the Commission ``seems to have adopted a 
five trade-per-day test to determine whether a contract is materially 
liquid. It is worth noting that ICE originally suggested that the CFTC 
use a five trades-per-day threshold as the basis for an ECM to report 
trade data to the CFTC.'' In this regard, the Commission adopted a five 
trades-per-day threshold as a reporting requirement to enable it to 
``independently be aware of ECM contracts that may develop into SPDCs'' 
\32\ rather than solely relying upon an ECM on its own to identify any 
such potential SPDCs to the Commission. Thus, any contract that meets 
this threshold may be subject to scrutiny as a potential SPDC; the 
threshold is not intended to define liquidity in a broader sense. As 
noted above, the Commission is basing a finding of material liquidity 
for the ICE SCL contract, in part, on the fact that there were over 100 
trades per day on average in the SCL contract during the last two 
reporting quarters of 2009, which was far more than the five trades-
per-day threshold that is cited in the ICE comment. In addition, the 
Commission notes that the number of contracts per transaction in the 
SCL contract is high (approximately 72 contracts per transaction) and 
thus, as noted, trading volume (measured in contract units) is 
substantial. The SCL contract also has substantial open interest.
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    \32\ 73 FR 75892 (December 12, 2008).
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    ICE also stated that ``the statistics [provided by ICE] have been 
misinterpreted and misapplied.'' In particular, ICE stated that the 
volume figures used in the Commission's analysis (cited above) 
``include trades made in all 120 months of each contract'' as well as 
in strips of contract months, and a ``more appropriate method of 
determining liquidity is to examine the activity in a single traded 
month or strip of a given contract.'' Furthermore, ICE noted that for 
the SCL contract, ``about 29% of the trades occurred in the single most 
liquid, usually prompt, month of the contract.''
    It is the Commission's opinion that liquidity, as it pertains to 
the SCL contract, is typically a function of trading activity in 
particular lead months and, given sufficient liquidity in such months, 
the SCL contract itself would be considered liquid. ICE's analysis of 
its own trade data confirms this to be the case for the SCL contract, 
and thus, the Commission believes that it applied the statistical data 
cited above in an appropriate manner for gauging material liquidity.
    In addition, ICE stated that the trades-per-day statistics that it 
provided to the Commission in its quarterly filing and which are cited 
above includes 2(h)(1) transactions, which were not completed on the 
electronic trading platform and should not be considered in the SPDC 
determination process. The Commission staff asked ICE to review the 
data it sent in its quarterly filings. In response, ICE confirmed that 
the volume data it provided and which the Commission cited in its 
October 20, 2009, Federal Register notice, as well as the additional 
volume information it cites above, includes only transaction data 
executed on ICE's electronic trading platform.\33\ The Commission 
acknowledges that the open interest information it cites above includes 
transactions made off the ICE platform. However, once open interest is 
created, there is no way for ICE to differentiate between ``on-
exchange'' versus ``off-exchange'' created positions, and all such 
positions are fungible with one another and may be offset in any

[[Page 24654]]

way agreeable to the position holder regardless of how the position was 
initially created.
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    \33\ Supplemental data supplied by ICE confirmed that block 
trades in the third quarter of 2009 were in addition to the trades 
that were conducted on the electronic platform; block trades 
comprised 45.7 percent of all transactions in the SCL contract.
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ii. Conclusion Regarding Material Liquidity
    Based on the above, the Commission concludes that the SCL contract 
meets the material liquidity criterion in that there is sufficient 
trading activity in the SCL contract to have a material effect on 
``other agreements, contracts or transactions listed for trading on or 
subject to the rules of a designated contract market * * * or an 
electronic trading facility operating in reliance on the exemption in 
section 2(h)(3) of the Act'' (that is, an ECM).
4. Overall Conclusion
    After considering the entire record in this matter, including the 
comments received, the Commission has determined that the SCL contract 
performs a significant price discovery function under two of the four 
criteria established in section 2(h)(7) of the CEA. Although the 
Commission has determined that the SCL contract does not meet the price 
linkage criterion at this time, the Commission has determined that the 
SCL contract does meet both the material liquidity and material price 
reference criteria. Accordingly, the Commission will issue the attached 
Order declaring that the SCL contract is a SPDC.
    Issuance of this Order signals the immediate effectiveness of the 
Commission's authorities with respect to ICE as a registered entity in 
connection with its SCL contract,\34\ and triggers the obligations, 
requirements--both procedural and substantive--and timetables 
prescribed in Commission rule 36.3(c)(4) for ECMs.
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    \34\ See 73 FR 75888, 75893 (Dec. 12, 2008).
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V. Related Matters

a. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \35\ imposes certain 
requirements on Federal agencies, including the Commission, in 
connection with their conducting or sponsoring any collection of 
information as defined by the PRA. Certain provisions of Commission 
rule 36.3 impose new regulatory and reporting requirements on ECMs, 
resulting in information collection requirements within the meaning of 
the PRA. OMB previously has approved and assigned OMB control number 
3038-0060 to this collection of information.
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    \35\ 44 U.S.C. 3507(d).
---------------------------------------------------------------------------

b. Cost-Benefit Analysis

    Section 15(a) of the CEA \36\ requires the Commission to consider 
the costs and benefits of its actions before issuing an order under the 
Act. By its terms, section 15(a) does not require the Commission to 
quantify the costs and benefits of an order or to determine whether the 
benefits of the order outweigh its costs; rather, it requires that the 
Commission ``consider'' the costs and benefits of its actions. Section 
15(a) further specifies that the costs and benefits shall be evaluated 
in light of five broad areas of market and public concern: (1) 
Protection of market participants and the public; (2) efficiency, 
competitiveness and financial integrity of futures markets; (3) price 
discovery; (4) sound risk management practices; and (5) other public 
interest considerations. The Commission may in its discretion give 
greater weight to any one of the five enumerated areas and could in its 
discretion determine that, notwithstanding its costs, a particular 
order is necessary or appropriate to protect the public interest or to 
effectuate any of the provisions or accomplish any of the purposes of 
the Act. The Commission has considered the costs and benefits in light 
of the specific provisions of section 15(a) of the Act and has 
concluded that the Order, required by Congress to strengthen federal 
oversight of exempt commercial markets and to prevent market 
manipulation, is necessary and appropriate to accomplish the purposes 
of section 2(h)(7) of the Act.
---------------------------------------------------------------------------

    \36\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------

    When a futures contract begins to serve a significant price 
discovery function, that contract, and the ECM on which it is traded, 
warrants increased oversight to deter and prevent price manipulation or 
other disruptions to market integrity, both on the ECM itself and in 
any related futures contracts trading on DCMs. An Order finding that a 
particular contract is a SPDC triggers this increased oversight and 
imposes obligations on the ECM calculated to accomplish this goal. The 
increased oversight engendered by the issue of a SPDC Order increases 
transparency and helps to ensure fair competition among ECMs and DCMs 
trading similar products and competing for the same business. Moreover, 
the ECM on which the SPDC is traded must assume, with respect to that 
contract, all the responsibilities and obligations of a registered 
entity under the CEA and Commission regulations. Additionally, the ECM 
must comply with nine core principles established by section 2(h)(7) of 
the Act--including the obligation to establish position limits and/or 
accountability standards for the SPDC. Section 4(i) of the CEA 
authorizes the Commission to require reports for SPDCs listed on ECMs. 
These increased responsibilities, along with the CFTC's increased 
regulatory authority, subject the ECM's risk management practices to 
the Commission's supervision and oversight and generally enhance the 
financial integrity of the markets.

c. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') \37\ requires that 
agencies consider the impact of their rules on small businesses. The 
requirements of CEA section 2(h)(7) and the Part 36 rules affect ECMs. 
The Commission previously has determined that ECMs are not small 
entities for purposes of the RFA.\38\ Accordingly, the Chairman, on 
behalf of the Commission, hereby certifies pursuant to 5 U.S.C. 605(b) 
that this Order, taken in connection with section 2(h)(7) of the Act 
and the Part 36 rules, will not have a significant impact on a 
substantial number of small entities.
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    \37\ 5 U.S.C. 601 et seq.
    \38\ 66 FR 42256, 42268 (Aug. 10, 2001).
---------------------------------------------------------------------------

VI. Order

a. Order Relating to the ICE Socal Border Financial Basis Contract

    After considering the complete record in this matter, including the 
comment letters received in response to its request for comments, the 
Commission has determined to issue the following:
    The Commission, pursuant to its authority under section 2(h)(7) of 
the Act, hereby determines that the Socal Border Financial Basis 
contract, traded on the IntercontinentalExchange, Inc., satisfies the 
statutory material liquidity and material price reference criteria for 
significant price discovery contracts. Consistent with this 
determination, and effective immediately, the IntercontinentalExchange, 
Inc., must comply with, with respect to the ICE Socal Border Financial 
Basis contract, the nine core principles established by new section 
2(h)(7)(C). Additionally, the IntercontinentalExchange, Inc., shall be 
and is considered a registered entity \39\ with respect to the Socal 
Border Financial Basis contract and is subject to all the provisions of 
the Commodity Exchange Act applicable to registered entities.
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    \39\ 7 U.S.C. 1a(29).
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    Further, the obligations, requirements and timetables prescribed in 
Commission rule 36.3(c)(4) governing

[[Page 24655]]

core principle compliance by the IntercontinentalExchange, Inc., 
commence with the issuance of this Order.\40\
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    \40\ Because ICE already lists for trading a contract (i.e., the 
Henry Financial LD1 Fixed Price contract) that was previously 
declared by the Commission to be a SPDC, ICE must submit a written 
demonstration of compliance with the Core Principles within 30 
calendar days of the date of this Order. 17 CFR 36.3(c)(4).

    Issued in Washington, DC, on April 28, 2010, by the Commission.
David A. Stawick,
Secretary of the Commission.
[FR Doc. 2010-10335 Filed 5-4-10; 8:45 am]
BILLING CODE P


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